The struggle to rebalance global oil markets

November 2016 | SPECIAL REPORT: ENERGY & NATURAL RESOURCES

Financier Worldwide Magazine

November 2016 Issue

Saudi Arabia has thrown in the towel on pumping up its oil output. The global oil war is over –assuming there ever was a war. Those promoting the war analogy cite OPEC’s November 2014 decision to let the market set oil prices as the start of the war against the frackers in America. Clearly, they were the enemy. America’s producers boosted US output by four million barrels a day, a 75 percent increase, in the 52 months preceding the OPEC meeting. US oil output had not been that high in 28 years. It climbed another half a million barrels a day before peaking early in 2015. Few observers at the time appreciated how this new supply was growing the global oil supply glut that was pushing down prices.

The view that oil prices would be ‘lower for longer’ was espoused by leading energy CEOs, but was considered unrealistic by most in the industry immediately after the OPEC meeting. The industry was coming off a multi-year run of $100 a barrel oil prices. Drilling was up, oil output was soaring and profits were growing. Oil company stock prices were higher and everyone was happy, except for OPEC which threw cold water on the industry’s celebration.

Emotions in the industry went from ebullient to being scared to death in less than 90 days. Bob Dudley of BP plc, Lance Ryan of ConocoPhillips and Paal Kibsgaard of service provider Schlumberger Ltd beat the drum for the ‘lower for longer’ view. They moved quickly to cut spending, lay-off employees and batten down the hatches as they readied their companies for an extended period of low oil prices and significant financial and organisational pain. Other executives believed that Saudi Arabia’s self-interest would eventually save the oil industry from self-destructing. US E&P companies grew their production, regardless of whether it was profitable or not. Wall Street was rewarding companies for growing output and not profits, because investors had bought into the idea that shale developments required huge initial cash investments with profits coming much later. Shale was considered a real estate play. Vacuuming up as much acreage as possible, even if it meant spending money to drill uneconomic wells to hold leases, was considered a sound business strategy.

Immediately following OPEC’s meeting, most oil executives could not imagine the industry being where it is now. Gone are hundreds of thousands of jobs, billions of dollars of shareholder wealth and billions of dollars of bank loans. The horrible experience of the 1980s industry depression – bankruptcy – was resurrected as the appropriate strategy for company survival, and for executives’ jobs.

Starting last February, oil prices rose from the ashes. From $27 a barrel, oil prices marched steadily higher to $50; the remarkable price rise brought sunlight to dispel the black doom embracing the industry. From $50 a barrel, people felt we were on the road to $80. Returning to $100 a barrel was considered possible – it was just a matter of time.

In mid-September however, following a drop in oil prices after they failed to breach the $50 a barrel barrier, the International Energy Agency issued its monthly report with a distressing message: “global oil demand growth is slowing at a faster pace than initially predicted”.

Despite industry preoccupation with oil output and inventory gyrations, demand is the critical ingredient for balancing the market, and for higher oil prices. The IEA cut its 2016 demand growth projection by 100,000 barrels per day, to an annual increase of 1.2 million barrels a day, down from its prior estimate of 1.3 mmb/d growth. Although this was only a small cut, the trend was unsettling.

After experiencing year-over-year growth of 2.3 mmb/d in the third quarter of 2015, demand only grew by 1.3 mmb/d in the fourth quarter, but then rebounded to 1.6 mmb/d in the first quarter of 2016, buoying hopes for continued consumption growth. In the second quarter, however, the growth rate fell to only 1.4 mmb/d, and is now projected to be 1.2 mmb/d for the third quarter. While many analysts, including the IEA, targeted a balanced oil market by 2016’s fourth quarter, or early in 2017, those outlooks now appear optimistic. The reported new OPEC agreement to cut its production, starting in November, may hasten that rebalancing, but that remains to be seen. Importantly, the IEA cut its 2017 oil demand growth forecast by 200,000 barrels a day to an annualised increase of 1.2 mmb/d. The cuts in demand projections will push out the timing of the resolution of the oil supply glut. But a year of lower OPEC oil supply will pull the date forward. Which force will be stronger?

The lower IEA demand outlook reflects ongoing global economic weakness. The International Monetary Fund reduced its global forecast, partially due to the UK’s decision to exit the European Union, as well as the continent’s terrorism and immigrant crises. Japan’s economy is stuck in neutral despite aggressive monetary easing operations by the Bank of Japan. The US remains mired in a slow-growth mode, highlighted by the Federal Reserve’s new long-term 1.8 percent growth projection. Lastly, China’s economic machine is sputtering, as the country’s leaders struggle to shift China’s economy from an investment to a consumption orientation.

The slow world growth outlook was reinforced by a revised global trade outlook offered by the World Trade Organisation as it cut its 2016 estimate to a gain of only 1.7 percent from its April projection of positive 2.8 percent growth. Historically, world trade expands at 1.5 times the rate of world economic growth, but this year the WTO sees it growing only by 80 percent. A key question is: Will the lower trade-to-economic-growth ratio continue in 2017? The answer may depend on what happens in China and the US.

Adding to the fallout from slowing global economic growth has been the dramatic decline in oil industry capital spending. We are approaching the time to set 2017 budgets for oil companies with macro conditions slightly more positive than a year ago, or even last spring when mid-year budget revisions were determined. Higher oil prices, plus the prospect of even higher prices next year, given the recent OPEC accord, suggest greater cash flows to support higher industry capital spending.

After falling by 25 percent in 2015, the IEA is predicting 2016 spending to decline by another 24 percent. The two-year reduction will have taken $300bn out of industry spending, leaving an estimated $450bn to fund drilling and completion activity. Besides cutting its 2017 oil demand forecast, the IEA also noted that it expects oil industry capital spending to fall, possibly below $400bn, or half the spending of three years ago.

Investment bank Barclays has a more optimistic view on industry capital spending. It sees E&P companies possibly spending 5 percent more in 2017. Bloomberg Intelligence also projects a small 2017 spending increase.

These years of reduced capital spending will take a toll on global oil & gas reserve growth. According to oil consultant Wood Mackenzie, in 2015 the oil industry discovered the fewest reserves since 1947, due to drilling fewer exploratory wells. This year the industry has drilled only 200 exploratory wells, the least active period since 1960. The impact will show up in five to 10 years’ time when oil prices jump due to limited oil output growth and slowly rising demand. That certainly is music to the ears of oilmen, assuming they are still in business in 10 years.

After nearly two years of pain, the new OPEC accord reflects oil exporting countries’ reluctance to continue enduring pain. This has boosted prospects for higher oil prices. When demand outruns supply, global inventories will be drawn down and oil prices should jump. The question is: Just how high? Possibly more important is what this two-year experience has done to company business strategies. The rapidity with which the industry moved from boom to bust, plus the two years of ‘living hell’, will colour executives’ thinking. The oil industry is now a prime target of environmentalists and consumer activists. What does this mean for oil industry long-term growth prospects? Our guess is that they are not as positive as the outlook before the 2014 OPEC meeting. As executives grapple with revised business strategies, energy investment banks should see their activity ramp up.

G. Allen Brooks is a managing director at PPHB. He can be contacted on +1 (713) 580 2742 or by email: abrooks@pphb.com.